Understanding currency effects on portfolio construction

Analysis - 7/6/2018

In short
  • There are three ways to manage currency exposure: systematic hedging, passive acceptance and active management. We prefer the third solution
  • Both in terms of risk and performance, it is impossible to ignore a portfolio’s currency exposure
  • Depending on the investment scenario, being exposed to a foreign currency like the US dollar, Japanese yen or Swiss franc can make portfolios more robust

Currency markets are more liquid, global and, and to a certain extent, complex. They are intrinsically linked to the macroeconomy and international trade as well as being open to speculators and central bank intervention.

Assessing a currency’s fair value is particularly tricky and it can significantly deviate from its equilibrium for some time. Currencies can also rapidly become highly volatile and entail serious losses. And yet direct or indirect currency exposure inevitably features in any diversified international portfolio. This makes it essential in our opinion to analyse and manage currency exposure as if it were a major asset class. Understanding currency effects on portfolio construction is a key part of investing.

We have highlighted three possible approaches to managing portfolio currency exposure. In the first case, currencies are part and parcel of the investment decision. This means a financial asset has dual positioning as a fund manager will take its base currency and its own merits into account. At the end of the day, a diversified international portfolio comprises several, and even a mosaic of, currencies. This approach adds another, sometimes, significant layer which can seriously impact returns for a multi-asset class account. Periods of US dollar appreciation, as in 1995, 1996 and 2012-13 when few currencies managed to resist the greenback, provide a convincing example. Note also that the impact of currency volatility is amplified when a portfolio has a defensive risk profile as foreign exchange volatility is stronger than contributions from other asset classes held. This aspect is often underestimated. As a result, a defensive portfolio should go for reduced currency risk. 

The impact of currency volatility is amplified when a portfolio has a defensive risk profile



The second case takes the opposite approach as the currency investment decision is unconnected with the underlying financial asset. This seeks to avoid having any currency exposure by systematically hedging any foreign currency. The basic premise is that over the long term, currencies do not create any value, or at least not enough, to offset their risk. Futures contracts are thus systematically used for each currency and rolled over at each expiry date so as to eliminate any currency risk. But this hedging comes at a cost, or an advantage, which can be estimated by comparing short term interest rates on domestic and foreign markets. The higher the differential, the bigger the performance deviation. In a diversified portfolio, this approach looks extreme and deprives the fund managers of any additional sources of returns. Moreover, some currencies are less liquid or subject to currency controls and can only be hedged with difficulty.

Currencies may play different roles depending on the economic cycle or prevailing market sentiment



The active approach is the nearest to our investment philosophy and in some ways combines the first two approaches. We start by considering that our international portfolio has neutral currency exposure, either because its takes no asset bets against the benchmark or because it has no absolute exposure. Each currency exposure is therefore a conscious, conviction-driven position. We separate our currency management from the investment decision and approach currencies as an asset class in their own right, forcing us to analyse each currency pair and its impact on the portfolio but also taking hedging costs into consideration. For example, in a Swiss franc portfolio, investing today in currency-hedged US bonds is not very attractive because of the interest rate differential between the US dollar and the franc, currently more than 3%, and an almost flat US yield curve. The expected net returns are in fact almost identical. The real plus in our approach is that we separate investment convictions from pragmatic currency management. We specifically recognise that currencies are an asset class that can generate additional returns while acknowledging that they can also create portfolio volatility. That is why we need genuine investment convictions before exposing a portfolio to currency risk. 

Conviction-driven exposure

It follows quite logically that our economists and strategists play a particularly important role. Financial models based on economic fundamentals, an econometric approach or simply purchasing power parity can help us assess the deviation between a currency pair’s intrinsic value and its current trading levels. However, these models are not always optimal at times of extreme valuation deviations and do not guarantee the timing of a return to fair value. Currencies like the Norwegian krone or the Swiss franc are famous for remaining systematically over or under valued.

To arrive at a short, medium or long term tactical vision, analysis must accordingly be rounded off with more subjective aspects like financial flows, traders’ speculative futures positions or by technical analysis. Recent US dollar moves show that a market may attach more or less importance to specific factors like budget or current account deficits before switching to, say, real interest rate differentials. For example, after treading water in the 1.22-25 range, the EUR/USD ended up dropping to around 1.16. In the end, we consider economic reasoning, and the direction and extent of an expected movement, as the motors behind an investment conviction.

Currencies as an asset class

Not all currencies have equal importance in the portfolio construction process. They may play different roles depending on the economic cycle or prevailing market sentiment. Their correlations and sensitivity to other assets can also undermine a particular conviction, hence the need to separate currency and investment decisions. For example, some currencies will move on commodity prices. The Russian rouble, the Norwegian krone and the Canadian dollar have some sensitivity to oil price shifts so investors should be aware that investing in roubles means de facto exposure to oil. The US dollar is generally seen as anti-cyclical, tending to appreciate when economic growth is on the wane and even when global trade slows. With this in mind, the risk of a trade war and the economic growth differential between the US and the rest of world could provide a little support for the US dollar to go higher. But emerging country currencies are negatively impacted by any dollar strength as they have significant foreign debt levels. It is the same negative sensitivity story for gold, and to a lesser extent, other metals are traded in dollars.

Being exposed to the dollar can thus create some stability in a portfolio. So, what should be the US dollar allocation in a portfolio exposed to emerging countries and gold when the dollar is rising? The question is not at all trivial as zero-dollar exposure is, statistically at least, the same as having negative, albeit variable, sensitivity. Ultimately, investors should know that other currencies like the Japanese yen and the Swiss franc often act as safe havens when financial markets are going through a turbulent phase. Recent episodes of financial market stress, for example when the yen moved from 121 to 100 against the dollar in the first quarter of 2016, saw investors retreating to these havens and triggering a rise in their currencies. We recommend being exposed to these currencies during unsettled markets. To sum up, we believe it is impossible to separate portfolio construction from currency exposure analysis. One the one hand, we look for strong ideas to generate additional performance and, on the other, we use currencies to stabilise diversified portfolios. More than ever, today’s highly volatile markets require, intelligent, responsive and tactical portfolio management. In our opinion, US dollar exposure currently helps stabilise portfolios and gain from any possible upside while a Japanese yen allocation will help attenuate the impact of any financial market turbulence.

 

Gilles Prince
HEAD OF DISCRETIONARY PORTFOLIO MANAGEMENT & CIO SWITZERLAND EDMOND DE ROTHSCHILD (SUISSE)


 

This analysis is an extract from the first House View published by Edmond de Rothschild. 

This publication presents Edmond de Rothschild’s key convictions for macroeconomics, asset allocation strategy, and the principal asset classes. 

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